Description

Wesco Aircraft (Ticker: WAIR)

Business description:

Wesco Aircraft, based in Valencia CA, provides distribution and supply chain management services to the aerospace & defense industry.  The company was brought public by the Carlyle Group in early August of 2011.  Wesco sells mainly to OEMs and subcontractors in the aerospace & defense industry, with approximately 53% of revenues derived from commercial markets, and 47% derived from military markets.  The company distributes hardware (~82% of revenues, consisting of fasteners, bolts, screws, clamps, etc.), electronic components (~12% of revenues, consisting of connectors, relays, switches, circuit breakers, etc.), as well as some other products such as bearings and machined parts.  Boeing is the largest customer, consisting of ~16% of sales in F’11, and the customer base is very fragmented after Boeing, with only two other customers accounting for more than 5%  of revenues.  The company sells product under three main types of agreements – JIT contracts (~29% of revenues), LTA contracts (~32% of revenues), and ad hoc contracts (~39% of revenues).  JIT contracts are typically 3-5yrs in length, and Wesco serves as outsourced supply chain management, providing quality assurance, re-ordering and re-stocking.  JITs are where Wesco is most involved in the supply chain of a customer, and rather than having the parts stocked at Wesco’s central facility in Valencia, JIT parts will be stocked at a “forward stocking location” (FSL) which is either in a customer facility, or near the facilities of several JIT customers.  LTAs also typically run for 3-5yrs, and are basically negotiated price lists that cover a range of pre-determined parts.  In LTAs, prices are typically tiered based on order size.  Ad hoc contracts are one-off orders from customers who either don’t have a JIT or LTA contract, or have orders outside of their contract terms.  Ad hoc contract revenues generate gross margins roughly 1,000bps higher than JIT and LTA sales.

Why this is a good business and why it is misunderstood:

Wesco is a broken IPO with a very attractive but misunderstood business model.

Wesco is a very attractive business.  The company helps its customers reduce cost through lower overhead, reduce capital needs through more efficient working capital management, and reduce risk through better on-time delivery of parts.  Wesco is able to do all this because if its scale – the company manages approximately 475k different SKUs across more than 7k different customers.  The business also has very sticky customer relationships.  Aircraft assembly is one of the most complex manufacturing processes in the world and Wesco is an important part of a manufacturer’s supply chain, often with a physical presence on their shop floor.  Lastly, fasteners typically represent ~3% of the total cost of an aircraft, so there is more focus on quality and timeliness than just price.  For these reasons, it is difficult to remove and replace Wesco from a customer’s supply chain.

Wesco is mispriced for three main reasons.  First of all, as a recent IPO with a financial sponsor still owning over 50% of the equity, the company went public during a period of stress in the capital markets (summer 2011), is not well known, and it is cited as illiquid (~$2m traded daily) with a secondary overhang.  We saw this same dynamic somewhat recently with Sensata, another high quality industrial, and the shares doubled from their post-IPO low as the company became better known and began putting up strong financial results.  In Sensata’s case, I believe the secondary offerings actually helped the valuation multiple, as they allowed investors to gain more familiarity with and appreciation of the business, as well as increased liquidity so larger funds could purchase shares.  I believe that a very similar dynamic exists for Wesco.

The second reason the company is mispriced is confusion around a distribution initiative that has been undertaken at Boeing Commercial Aircraft.  The initiative covers Boeing Commercial Aircraft specific parts at tier 1 and tier 2 suppliers.  The initiative allows BCA suppliers to buy fasteners directly from manufacturers through a distributor called New Breed, which was selected by Boeing.  This initiative has people worried that Wesco’s business model is being disintermediated.  I don’t believe this to be the case.  First of all, while Boeing accounts for ~15% of Wesco’s revenue, only 6-8% is from parts specific to Boeing Commercial Aircraft.  The remainder is Boeing Defense, which has its own fastener strategy, and parts that are on Boeing aircraft but not Boeing-specific.  Second, the BCA initiative only covers a fraction of Wesco’s ~475k SKUs, so in order to participate, a supplier would have to use one distributor for BCA parts, and keep Wesco for the remaining.  This would prove difficult logistically, especially in JIT relationships where Wesco is heavily ingrained in the supply chain management process.  Lastly, the initiative does not force suppliers to use New Breed, but is just meant to ensure supply at reasonable prices.  That said, New Breed is a small distributor, so could prove difficult to rely on for scale.  In addition, while Wesco makes healthy margins, it buys cheaply due to its scale, so its customers are already getting an attractive price.  So far, despite the hype, Wesco reports not having lost any business based on this initiative.

The third reason I believe the company is mispriced is its exposure to the defense industry.  There is, for good reason, a lot of concern about future levels of defense spending, and Wesco derives 47% of its revenues from defense.  However, Wesco has a history of significantly outgrowing the defense industry, as it has also done in its commercial business.  Wesco’s defense growth relative to the base budget has actually been greater than the growth of their commercial business relative to aircraft deliveries.  This demonstrates the solid history of Wesco’s ability to gain share within its end markets.

Lastly, I think it’s worthwhile pointing out that management still owns ~15% of the equity in the business, so they are well aligned with investors.

Earnings power:

Wesco generated $711m in revenue, $179m of EBITDA, and $0.97 of EPS in their Fiscal 2011.  Initial guidance for F’12 is $760-785m in revenue and $1.03-$1.07 in EPS.  I believe the business will generate closer to $800m in revenues in F’12, over $200m in EBITDA and over $1.10 in EPS.  I also estimate that revenue, EBITDA and EPS CAGRs over the next three years will be roughly 15%, 17% and 22%, respectively.  Uses of cash should be primarily 1) funding inventory, and 2) debt paydown.

Wesco’s growth projections are built mainly on 1) growth in excess of commercial aircraft builds and the defense budget due to share gains from new customers and product lines, and 2) accelerating ad-hoc sales.  The company has an excellent history of gaining share and outgrowing both commercial aircraft deliveries and the base defense budget.  In the ’03-’09 period, the company’s commercial revenues outgrew commercial aircraft deliveries by mid to high single digits per year, and the company’s defense revenues outgrew the defense budget by greater than 10% per year.  I believe this will be true going forward as well, and is evidenced by recent customer wins such as Gulfstream in the commercial business, Raytheon missile systems in the defense business, and increased share on the JSF at customers such as BAE and Northrop.

Additionally, accelerating ad-hoc sales should help drive revenue growth.  Ad-hoc sales increase as aircraft build rates rise and lead-times for hardware lengthen.  We have already started to see build rates rise, and the company is reporting that hardware lead times are lengthening as well.  Ad-hoc as a % of sales in F’11 was 39%, is expected to be 42-43% next year, and should continue to rise from there.  In the last cycle ad-hoc revenues as a % of total, peaked at over 50% in 2007.  Wesco since acquired Airtechnics (2008), which is 90% ad-hoc, so an apples-to-apples comparison would be even higher.

In addition to revenue growth, margins should also expand at Wesco over the next several years.  Not only will the company enjoy some modest fixed cost leverage, but gross margins should benefit as ad-hoc sales accelerate.  Because of their last-minute, non-contractual nature, ad-hoc revenues carry gross margins roughly 1,000 basis points higher than JIT or LTA revenues.

Valuation:

Given that Wesco has solid growth opportunities that can be internally funded at attractive returns, instead of a 12mo price target, I am targeting  a three year IRR.  My financial projections of revenue, EBITDA and EPS CAGRs of 15%, 17% and 22%, respectively, a 10x EBITDA exit multiple, and use of excess cash to de-lever the balance sheet, generates an IRR of approximately 30%.

The best publicly-traded comparable for Wesco is  BEAV, which trades at 10x EBITDA.  Fastener distribution is ~40% of BEAV’s business.  Wesco, however, is a better run business, generating higher margins and returns than BEAV.  BEAV breaks out the income statement and balance sheet data for its various segments, so we can get a relatively clean comparison of BEAV’s Consumables segment (their distribution business) to Wesco.  Whereas BEAV’s Consumables business generates a roughly 20% operating margin, Wesco’s is closer to the mid 20s.  In addition, BEAV only generates an ROA of 8%.  Wesco’s ROA, using book assets, looks lower than this, but that is in large part due to the $505m of goodwill on their balance sheet.  The majority of this goodwill relates to Carlyle’s acquisition of the business, so it is not applicable to the economics of Wesco’s business.  Wesco did acquire Airtechnics for $109m in 2008, so this goodwill should be applied to the ROA calculation.  For the sake of conservatism, we’ll apply the entire Airtechnics purchase price as goodwill on the balance sheet (so good will drops from $505m to $109m).  After making this adjustment, Wesco’s ROA jumps to the mid to high teens.

In addition, BEAV just bought UFC Aerospace Corp, which is also good comp for Wesco.  BEAV bought UFC for $400m, or roughly 11x EBITDA.  UFC has low 20% EBITDA margins, and distributes over 150k SKUs to over 1,000 customers (mainly aerospace OEMs).

Lastly, other industrial distributors such as FAST, MSM and GWW provide very favorable valuation comps. 

As a sanity test, the above construct implies an earnings multiple in the mid-teens.  For a company generating mid to high teens ROA, with underlying growth and a history of gaining market share, I believe a mid-teens earnings multiple is reasonable.

Balance sheet and liquidity:

Wesco has $556m in gross debt, made up of two term loans maturing in 2016 and 2017.  The company also has $45m in cash, as well as an undrawn $150m revolver.  While 2.9x net leverage is not low, it is very manageable for Wesco given the maturity schedule as well as the fact that, typical of a distribution model, the business generates significant cash in a downturn.  Lastly, the company should continue to use excess cash to de-lever the balance sheet.

Catalysts:

I believe that earnings and secondary offerings will be catalysts for Wesco, again a similar dynamic to Sensata which I mentioned earlier.  Earnings and secondary roadshows will help dispel the misunderstanding around the Boeing initiative, and help to highlight the quality of the Wesco model.  The liquidity of the stock should also increase, allowing larger funds to initiate positions.

Risks:

Disintermediation:          There is a chance I am wrong on my analysis of the Boeing initiative.

Economic growth:            Slower economic growth could lower growth rates in the commercial business.

Government budgets:   Baseline defense headwinds for Wesco could be greater than anticipated.

Catalyst

I believe that earnings and secondary offerings will be catalysts for Wesco, again a similar dynamic to Sensata which I mentioned earlier.  Earnings and secondary roadshows will help dispel the misunderstanding around the Boeing initiative, and help to highlight the quality of the Wesco model.  The liquidity of the stock should also increase, allowing larger funds to initiate positions.